Investing requires people to make tradeoffs between expected risk and expected return. Consequently, many investors have turned to sophisticated models to help develop their expectations. Ron Rimkus evaluates why these models only capture risk relative to the market and do not do an adequate job of assessing systemic risk.
We hear a lot about systemic risk, what exactly is it?
Systemic risk refers to the risks that originate from the functioning of the financial system as a whole. Unfortunately, we have come to a point in time where the risk in the system is growing for a variety of reasons. As an industry, we do a poor job of managing that risk as evidenced by the financial crisis that began in 2007 and spread around the world.
What is systemic risk and what can we do about it?
It’s easier to think about systemic risk in terms of factors that increase systemic risk and factors that reduce it. Some notable factors that increase systemic risk include outsized growth in debt relative to assets, material changes in the ability or willingness to meet financial obligations and rising current account imbalances across national economies. Conversely, factors that reduce systemic risk act in the opposite direction.
Why is systemic risk more of a problem for investors today than it has been in the past?
Over the past several years we have witnessed an explosion in bubbles and complexity of the system. This has been offset somewhat by productivity growth and modest inflation. Nevertheless, the growth in the negative factors is greater than the growth in the positive factors. So, on balance, systemic risk is increasing.
What role does today’s foreign exchange system have in creating or mollifying systemic risk?
Since US President Nixon moved off of the Bretton Woods Gold Exchange Standard in 1973, the leading countries have operated on a purely fiat money basis.
Consequently, today’s monetary system enables countries to maintain current account imbalances, which would otherwise self-correct, to persist. In so doing, some countries have built up sectors that become uncompetitive when local currency exchange rates change.
What role do central banks play in creating or mollifying systemic risk?
When central banks set interests rates that are different from what free markets would determine on their own, it increases systemic risk. Likewise, when central banks act as lender of last resort, they effectively bail out banks that made poor choices and hence prevent the economy from allocating capital to only the best run banks. Over time, it reduces the quality of banking in general and increases risk to the system globally. So, investors need to follow these systemic issues closely to identify whether specific actions are increasing or reducing systemic risk as central banks are capable of both.
What are some other sources of systemic risk that have increased in recent years?
Hidden sources of leverage not only increase the leverage in the system, but also decrease the trust and confidence in the system during periods of stress. Since the crisis, many smaller corporations have increased their reliance on bank loans and non-bank loans.
The next time the banking system turns sour on extending new credit, these corporations will be unable to roll over their debt, placing greater importance on cash and liquidity at a time when the economy is likely heading into recession. Of course, measuring systemic risk is a whole other problem. Some have suggested a simple scoring system that weighs the magnitude and direction of each of the systemic risk factors as one way for investors to overcome this challenge.
Ron Rimkus is Content Director, Economics and Alternative Investments at CFA Institute
